As the health and economic impacts of COVID-19 continue to reverberate through the United States and the rest of the world, many businesses and individuals are reeling. We face unknowns about depth and duration, and this uncertainty has an impact on all aspects of the economy, including public and private company valuations.
The more uncertainty in the marketplace, the lower the value of a particular business. This trend can be easily observed for public companies. For example, tech’s “big five” (Alphabet, Amazon, Apple, Facebook, and Microsoft) lost a combined $1.3 trillion in value between February 19 and March 19. The decline in valuation is clear and readily apparent because these shares trade every day, and because their closing stock prices are published and discussed in the media.
While it isn’t as immediately apparent because equity interests aren’t publicly traded, private businesses are also seeing the value of their companies reduced. Let’s look at why that is, and a few steps businesses can take to mitigate the impact of uncertainty on private company valuation.
Business Valuation Methods and Risk
Growth, Margin, and Risk are the fundamental drivers of business value no matter which valuation method an appraiser chooses to value a business (market approach, income approach, or asset approach).
Market approach to business valuation relies on the stock prices or transaction prices of similar companies. Today, stock prices can be significantly lower than they have been over the past three years, yielding lower valuations.
Income approach relies on expected future income to determine value. With uncertainty about future prospects (like how quickly the economy will recover), future cash flows and earnings margins are lower, especially in the short-term.
Asset or cost approach relies on the assets of a business. With market uncertainty, the value of many assets decreased, like real estate holdings or excess inventory.
Revenue and cash flow levels drive value in the market and income approaches. The current environment has two effects on cash flow levels that impact valuation: short-term and long-term.
Short-term effects are more certain. If a retail store is closed for the next 30 days, this will clearly lower their earnings and cash flow for 2020, which lowers the valuation. The impact can be measured with some degree of certainty, and the primary unknown is the length of the shutdown.
Long-term effects are more uncertain, and more difficult to measure than the short-term impacts. Will people fundamentally change habits that will impact the business? For the retail business, will more people shift to online ordering and product delivery? If so, it could change the business for years to come. Or, if some portion of the workforce will continue to work from home beyond the current COVID-19 crisis, companies will reduce their overall office footprint going forward, and that will impact commercial real estate and businesses that serve this industry. Is there a long-term impact on the cash flow that could fundamentally lower the financial projections?
Lower cash flow, risk and uncertainty impact company valuation across all valuation methods. Discount rates are based partially on data from public markets (more volatile now) and based partially on the risk of failing to meet financial forecasts (more likely to miss projections now).
Company-specific risks (like reliance on a key person) are typically higher during economic downturns, resulting in even lower valuations. Appraisers must identify and judge each company’s unique company-specific risk factors to provide an accurate assessment of value. These company-specific factors will vary over time within the same company due to external forces (like those happening now) and internal changes. What changes can be made now to lower risk and increase earnings consistency?
All these points assume you are in control of a business, but what if you are not? There can be significant discounts for Lack of Control. In uncertain times, the discounts for Lack of Control increase. Furthermore, as buyers prepare for opportunistic buying, a fairly priced transaction simply will not get attention. To attract a buyer in uncertain markets, lower pricing may be your primary sales tool.
Mitigating Loss of Value with Long-Term Thinking
In the midst of a crisis, there are strategies that companies can take to mitigate the loss of value being felt across the marketplace. As tempting as it might be, business owners can’t focus solely on volatility and uncertainty. It’s even more critical that you think about long-term success, financial health, and personal health.
For some companies, this might mean making an investment. As Warren Buffet famously says, “Be fearful when others are greedy and greedy when others are fearful.” Grocery stores, for example, might have an opportunity to invest in additional staff to help them stock shelves more quickly. Are there opportunities to make changes to a business which capitalize on potential long-term behavior shifts? Other businesses, however, are contracting. In those cases, long-term thinking might result in the difficult choice to let people go.
The volatility due to COVID-19 can sometimes be mitigated with creative thinking. Businesses need to think about what consumers are looking for and how they can pivot to meet those demands. Local gyms are offering online fitness classes via Facebook or YouTube. Bookstores are offering curbside pickup. Bands are offering online performances. Companies meeting customers where they are during this pandemic will most likely result in higher private company valuation over the long term.
Finally, if a business is in a position to do so, finding genuine ways to help can foster long-term credibility and goodwill — and it’s the right thing to do. Just a few examples:
Christian Dior has started making hand sanitizer instead of perfume to help with supply shortages.
Cycling clothing manufacturer Santini, based near Bergamo in northern Italy, has started producing face masks. Other small businesses are finding ways to donate their stock of masks as well.
Georgia Tech students are making face shields for hospitals with 3D printers and laser cutters in the School of Mechanical Engineering workshops. (I’m on the Mechanical Engineering advisory board and very proud of these students.)
Dealing with Economic Uncertainty
With the market uncertainty and uncertainty in our lives, the value of private businesses is taking a hit. With smart long-term thinking, many can avoid lasting impacts on the value of their business and position themselves for a strong recovery when the crisis is over.
Adams Capital always offers a no-cost initial telephone consultation to provide a sounding board to business owners struggling with these difficult decisions.
Please email us at tara@adamscapital.com or call us directly at 770-432-0308 to schedule a consultation or to learn more.